March madness canceled. Ice hockey thawed. No baseball. Schools closed. Restaurants offering curbside pickup. Breweries doing delivery. Supply chain disruption. Hoarding. Entire companies working remotely. No toilet paper on the shelves! Trump. Congress. COVID-19 vaccine. Social distancing. Stay at home. Olympics delayed. N95 masks. SXSW scratched. Distance learning. Concerts delayed. Disney locked. Group meetings? Fuhgeddaboutit! The headlines sound like new lyrics to REM’s famous title “It’s the End of the World as We Know It.”
What does it mean for a Company’s business valuation? Coronavirus, or COVID-19, muddies business valuations for an indeterminable period. Many businesses will be adversely affected by reduced sales, uncollectible receivables, staff absences for a variety of reasons, increased costs of operating remotely, increased sanitation costs when out of the office work is not feasible, etc.
Other companies will be fine, and COVID-19 will not have as much of an impact on their operations. Or they may even see an increase in demand for their services. Amazon’s stock price is up over 6 percent since the public market volatility began in late February, while the broader market is down over 20 percent. The problem is we do not know which companies will weather the storm and make it through.
Let’s look at this through the lens of the income approach – cash flow, growth, and risk. Each of which may be impacted by current events.
The current market conditions are unique and extraordinary for any business. Cash flow is defined as the earnings stream the business expects to generate in perpetuity. Whether you consider historical or projected outcomes, it is based on the valuation analyst’s review of the subject Company’s operations and input from management. During this period of economic uncertainty, operating results may or may not be adversely affected by the effects of COVID-19. The impact on a particular Company could be temporary or permanent.
Cash flow projections (and actual current cash flow) may have decreased due to forced COVID-19 closures or decreases in demand. The Company may have to increase its borrowings to pay essential employees and other fixed expenses. The cash flow of a Company depends on the revenues generated by the Company minus its expenses. When the revenues are reduced, the impact is immediate to a Company’s profit or net income and in turn a reduction in cash flow. This cash flow reduction will negatively affect the value of a Company, at the very least in the short-term. And possibly in the long-term.
So, what is a valuation analyst to do about projected cash flows? Use your training. Perform an analysis of the current and expected market conditions based on what is known or knowable as of the valuation date. Determine the impact of these factors on the subject Company’s expected growth rate. Reflect uncertainties in the projected cash flow. Finally, consider reporting any material developments as a subsequent event if these events occur after the valuation date.
The valuation of a Company should reflect the projected growth in earnings and cash flow for the foreseeable future. This is important for investors as they seek to understand the long-term sustainability of the Company. When an event like COVID-19 is taken into account, it is difficult not to reduce the economic perspectives on growth, at least in the short-term. We still don’t know how long the economy will be impacted by COVID-19 and that creates problems with determining medium-term and long-term growth rates. With a lower growth forecast, the subject Company becomes less attractive to potential investors as the uncertainties mount over time. This, obviously, has an impact on the value of the Company.
The twenty-year treasury was 2.25 percent as of December 31, 2019. Year-to-date it fell as low as 0.87 percent on March 9, 2020. That is 138 basis points in just over two months. The twenty-year rate has recovered slightly to 1.23 percent as of March 25, 2020. However, it is still down over 100 basis points since year-end. Does this mean risk at privately-held Companies fell during this period? Far from it! The impact on the cost of equity is likely far more than that movement in the twenty-year treasury rate, and in the opposite direction from that indicated by the build-up method or adjusted CAPM approach. Some of the reasons to expect increased risk include uncertainty as to the duration of the quarantines, illiquidity in the markets, and amplified market volatility.
Changes in interest-bearing debt will also influence the overall risk of the Company. The weighted average cost of capital (“WACC”) will be impacted. Will the Company have the cash flow to service the new debt? How long will the new debt be a factor in the Company’s capital structure? Do we need to consider modifications to the risk-adjusted discount rate in later periods of a forecast? How will the inputs to determine risk in 2021 or 2022 or later be modeled? What will those inputs realistically be based on?
A risk-adjusted discount rate must be considered in the income approach. There is no set approach to account for market uncertainties as the impact will be different for different businesses in different regions. The Company-specific risk premium and the analysis behind it are critical. The factors which comprise this component will vary from Company to Company, from industry to industry, and over time within the same Company.
Risk has a direct impact on the valuation conclusion. The higher the risk, the lower the overall valuation determined in the income approach.
Other Areas of Valuation Concern
ESOP repurchase obligations
As the COVID-19 pandemic wreaks havoc medically, socially, and economically, many ESOP companies and advisors are currently working on wrapping up December 31, 2019 valuations. A fundamental rule of valuations is that the valuation is based on all of the information that was known or knowable as of the date of the valuation. That means COVID-19 has no impact on a December 31, 2019 valuation. COVID-19 was simply not a factor until the end of February 2020.
ESOP participants will still be paid out based on that December 31 valuation. What if the Company faces a devastating loss of revenue this month or next month or for the rest of the year? What if making those share purchases from 2019 would result in a significant liquidity problem for the Company? COVID-19 worldwide pandemic or not, there is an obligation to meet. However, this is an issue that ESOPs have always faced when presented with a valuation conclusion resulting in a greater repurchase commitment than it might have anticipated.
Triggering events for impairment analysis
Public company management must be prepared to announce “immediately” any impairments or other factors that could impact the share price significantly. It is a very low and arbitrary bar. It may imply that management has little choice but to impair. However, how do they know when or if the triggering event known as COVID-19 has concluded?
Companies may need to assess whether an asset impairment has occurred as a result of the impact of COVID-19. A Company’s current financial performance or estimates of future earnings may be affected by the loss of a significant supplier or customer whose own operations are impacted by recent events. Companies will need to assess whether a triggering event has occurred, and if it has, management should follow the applicable accounting guidance.
How do you conduct a site visit and management interview?
Inability to travel. No in-person meetings. Failure to perform complete due diligence. There is a real potential for loss of key intelligence that would have otherwise been available through “kicking the tires” at a site visit. Though the loss of a site visit is a huge loss, meetings and in-person communication can still be maintained as best as possible through video calls, provided by RTC networks like Agora.io for the best sound and visual quality. This will somewhat maintain some communication that would’ve been done at a site visit.
The health of our family, friends, colleagues, clients, and neighbors is foremost at this time. These are abnormal conditions in the market. However, there are similarities to other recent crises like 9/11 and the 2008 financial crisis. Still, there are no empirical data to quantify the exact changes to the factors that drive value under the income approach due to COVID-19. Valuation experts will have to rely on their SKEET – skills, knowledge, education, experience, and training. And their professional judgment. In time, this too shall pass.
It may yet be too soon to say what the long-term effect COVID-19 will have on the economy or the valuation of privately-held businesses. We may have to simply wait it out. The burning issue may be how privately-held businesses can best utilize their current resources to support their results in the short-term and address long-term strategic goals.
Members of the Business Valuation Practice Group of Evergreen Advisors offer you reliable business valuation advice and well-reasoned opinions. Our findings are supported by actual market transactions, the most recent industry and economic research, the latest in valuation methodologies, and actual transaction experience. We have experience with a wide range of industries and can assist you with a variety of business valuation advice in connection with the following services: Estate and Gift Tax Planning, Fair Value for Financial Reporting, Equity Incentive Plans (409A), Employee Stock Ownership Plans (ESOPs), Transaction Support, and Fairness & Solvency Opinions.
Have questions? Please contact us at 410-997-6000.